Sharpe did not offer a precise definition of which strategies he would include in the definition of smart beta. But in an email exchange, he wrote that it would at least include portfolios that overweight small-capitalization or value stocks, as well as alternative weightings, including fundamental indexing.

I think that’s an excellent definition of smart beta. To me, it’s a rules-based strategy (so you can replicate it at home,) and it has its basis in behavioral investing theories. That is, long term proven factor differences that persist over time, and regimes, and across countries. The biggies are size, value, and momentum.

Rob Arnott must be just in awe of how this term he made up has taken off. It’s got to be great for his business, but he probably did not anticipate this much blowback.

More from Mr. Sharpe:

The question Sharpe posed for a smart beta portfolio is whether it can be good for everyone. If so, then that would imply that he and his friends are dumb, because they hold the market portfolio. Other investors who underweight those stocks that are overweighted by the smart-beta strategies must be “really dumb,” he said.

The market must therefore be divided between smart, dumb and really dumb investors.

I don’t think that’s what Arnott intended by that name. At all. He’s not calling you and your friends stupid.

Amazingly, later in the article, the interviewer asks questions essentially about EMH vs. behavioral theory, and passive vs. active investing, and Sharpe comes out in favor of both. This is kind of obvious, but you don’t often see it stated this way:

Returning to the topic of smart beta, Sharpe acknowledged that index funds have their limits too. “We absolutely need people who are looking for mispriced securities,” he said. If all investors held index funds, then the shares of those funds would be bid up. Active management provides a social service, he said, that benefits index investors.

He said he used to worry about too much indexing. “But human nature is such that people will continue to look for under- and overpriced stocks,” he said. “I stopped worrying.”

To me, this is exactly the argument in favor of smart beta.

As long as “people will continue to look for under- and overpriced stocks,” then I expect we will see persistence in some of the behavioral biases. I mean, the size and value factors have been out there for a LONG TIME, and still persist. Maybe not all of the smart beta strategies will be successful long term, as I have seen research showing that the size factor has been decreasing as a source of improved risk-adjusted returns. That just means that anyone using smart beta will need to be vigilant – advantage, indexing. So I guess he’s right that smart beta implies the rest of the market is dumb, and that those advantages should not persist. But I wouldn’t say the people are dumb. They’re just people, behaving like people.

I like the idea of investing in the whole market, but maybe in weights that are calculated to take advantage of the human behavior of all the people who are not indexing. Momentum will even take advantage of behavior biases for those investors/traders using index funds. After all, non indexers are always going to be, as Sharpe notes, a significant proportion of the market.